Hedge Fund Strategy Outlook

Q4 2018

To begin each quarter, the Research and Portfolio Construction teams at Franklin Templeton’s K2 Advisors share their outlook for hedge strategies.

Alpha is Hard

For this quarter's outlook we are taking a deeper look at alpha. For hedge funds the importance of this measure cannot be overstated. The problem, from our perspective, is that often it is misunderstood. From a purely qualitative standpoint investors understand alpha as the value that an active portfolio manager adds to or subtracts from a fund's return, depending upon his or her skill as an investment manager. Fair enough. But when conversations turn to measuring this fleeting statistical phenomenon, things can get a bit more ambiguous.

Often alpha is talked about in the abstract. A precise quantitative measure is sometimes not specified or, if it is, the calculation may be flawed. Ad hoc or loose definitions are also often used and never tested for validity.

To be clear, we are not casting aspersions. We understand the challenge. For all intents and purposes, alpha - in the purest mathematical sense - is hard. It is hard to quantify, hard to consistently measure, and even harder to capture. Sometimes asset management marketing materials describe “generating” alpha. To be precise alpha cannot, in fact, be “generated.” It can only be captured - and it is in short supply. Over time and across markets it represents a zero-sum game. To obtain alpha means taking it away from someone else.

Mathematically speaking (and we are sorry for this), alpha represents the abnormal rate of return on a security or portfolio in excess of what would be predicted by an equilibrium model like the capital asset pricing model (CAPM). The CAPM says that the expected return for an investment is proportional to its exposure to systematic, or non-diversifiable, risk. In plain English, any investment should earn whatever the risk-free rate is (let's say Treasury bonds… for now), plus any premium associated with the level of market risk taken (or so-called beta).

Taking it a step further, alpha is the coefficient - or residual of the expected return. In an efficient market, the expected value of the alpha coefficient would be zero; however we find markets to be decidedly inefficient. As such, if a fund or security returns more than what would be expected given its market sensitivity (beta), it has positive alpha. If it returns less than its beta predicts, it has negative alpha. So in the simplest of terms, alpha is the portion of a portfolio's return that is the result of factors other than the portfolio's exposure to the market.

Measuring alpha in alternatives presents an additional layer of complexity. Defining market beta is challenging. Remember many alternatives (not all) are considered “absolute return” vehicles, that is they are not tied to any given benchmark. Take hedge funds for example. While hedge funds can be measured against traditional market benchmarks such as the S&P 500 Index, to identify a hedge fund's beta profile requires insight and transparency into its trading strategy and the securities in which it invests. In this way the systematic risk exposures can be understood and measured.

In our view, the good news is that alternatives and other select investment strategies deliver measurable alpha, provided that the appropriate methodology is used. That said, it is important to recognize that measuring and monitoring alpha is a variable exercise contingent upon each individual manager's investment program, and the securities in which they invest. Traditional measures and reports of alpha often fail to control for the statistical artifacts that can significantly alter the meaning of reported numbers. Just something to bear in mind. You cannot measure what you cannot see…and alpha is no exception.

Relative Value - Fixed Income

With interest rates starting to rise, duration risk is coming into focus for fixed income investors, such as in the high yield market. In our view, relative value fixed income strategies such as long/short credit are well positioned, given their shorter duration portfolios, and should be able to capture alpha from rising sector dispersion.

Past performance is not an indicator or a guarantee of future performance.Source: BofA Merrill Lynch. High Yield market represented by the ICE BofAML US High Yield Index. Important data provider notices and terms available at www.franklintempletondatasources.com. Indexes are unmanaged and one cannot invest directly in them. They do not reflect any fees, expenses, or sales charges.not reflect any fees, expenses or sales charges. Unlike most asset class indexes, HFR Index returns reflect fees and expenses. Source for HFR: Hedge Fund Research, Inc. - www.hedgefundresearch.com. The HFR indices are being used under license from Hedge Fund Research, Inc., which does not endorse or approve of any of the contents of this report.

As you can see, when interest rate level averages have been at their lowest, represented by the first quintile bar on the left, average alpha levels have also been at their lowest. But as we move from lower yield levels to higher average levels across the five quintiles, we see a corresponding rise in average alpha as well.

While we know that past performance doesn't guarantee future results, clearly higher nominal yields of US government bonds, such as five-year Treasuries, have on average historically corresponded with increased average annualized hedge fund alpha capture as well. In our experience, the vast majority of hedge funds are defensive with respect to interest rate risk, while some macro managers see it as a speculative opportunity.

The implication of sharply rising rates for individual and institutional portfolios, particularly for fixed-income investments, could be troublesome as they may be confronted with diminishing returns or potentially significant losses – depending upon duration risk and the magnitude and velocity of any rate rise.

We believe an alpha boat is the best option available to hedge against the eventual attack.

Event Driven - Merger Arbitrage

Corporate activity is expected to remain strong in 2019 . The successful completion of the AT&T/Time Warner transaction is expected to lead to an increase in deal activity in the media industry, as well as a broadly more favorable outlook on vertical mergers. Tailwinds for corporate activity also persist, including corporate tax cuts, cash repatriation, high CEO confidence, and strong credit markets. The most significant headwind is the trade war between the US and China.

Global M&A Activity (January - August)

Volume (lhs)

Deal Count (rhs)

Source: Bloomberg as of 8/31/18. Global merger and acquisition (M&A) transactions over $500mm from January to August.Past performance is not an indicator or guarantee of future results.

Discretionary Macro

In our opinion, there are many potentially attractive trade opportunities for discretionary managers stemming from macro divergence between countries and their resulting policy responses, important political elections, and international trade negotiations. The recent weakness in emerging markets may also present an attractive entry point, but volatility and potential risks remain elevated.

Target Rates of Central Banks Around the WorldAs of August 31, 2018

2016 Change

2017 Change

2018 Change

Source: Bloomberg as of 8/31/18. Most central bank rates are expressed in overnight terms (the rates depository institutions pay to borrow money from the central bank), however some exceptions apply. Past performance is not an indicator or guarantee of future results.

12-MONTH OUTLOOK SUMMARY FOR Q4 2018

Neutral

Up Trend

Down Trend

Strategy

Conviction Sentiment

Summary Statement

Long/Short Equity

We maintain a positive outlook for long/short equity managers. Investors’ growing appetite for risk-off assets driven by a variety of factors, including the anticipation of the end of the nine-year bull run, ongoing trade wars, upcoming political elections, and turbulent emerging markets, has overshadowed the strength in U.S. corporate fundamentals. In our opinion, improved market conditions, including a rising rate environment, lower correlation, and higher dispersion, should allow managers to generate alpha in both the long and short books.

Relative Value

The less directional nature of relative value strategies remains attractive amidst the greater uncertainty in the markets. We maintain a slightly positive view for convertible arbitrage and a neutral outlook for fixed income arbitrage. We also maintain a favorable outlook for volatility arbitrage with an attractive entry point to maintain long-biased volatility profile (potentially benefiting from market dislocations).

Event Driven

Corporate activity in 2018 remains strong globally and is forecast to remain strong through the second half. Tailwinds for corporate activity continue – corporate tax cuts, cash repatriation, high CEO confidence, and strong credit markets. The most significant headwind is the trade war between the US and China. Merger arbitrage spreads remain attractive relative to Treasury yields while special situations and activism should be more equity market dependent.

Credit

Interest rates are starting to rise, and duration risk is still prevalent in the credit markets. Long/short credit managers have naturally shorter duration portfolios and should benefit from increased dispersion. Defaults remain low with limited new opportunities. In structured credit, fundamentals remain strong and yields look attractive to us on a relative basis. In private credit, we prefer niche strategies.

Global Macro

The opportunity set for discretionary macro managers remains attractive to us as short-term dislocations around events like elections and policy changes are creating opportunities. We are more cautious on emerging markets strategies, which face headwinds from more frequent external factors like trade tensions and portfolio flows. Systematic strategies could benefit from lower medium-term cross-asset correlation but are susceptible to exogenous dislocations.

Our Top Convictions

Relative Value – Fixed Income

The diverging paths of central banks in the major global economies are expected to present improved directional opportunities. Participation from directional buyers and sellers of bonds should result in greater market inefficiencies between cash bonds and futures, benefiting less directional relative value trading. The strategy is still subject to greater leverage and funding risks, justifying the cautiously optimistic rating.

Event Driven – Merger Arbitrage

CEO optimism remains high, and we believe corporate activity will remain robust and potentially increase due to tailwinds from tax cuts and cash repatriation. In our opinion, merger arbitrage remains an attractive strategy for investors seeking more consistent returns with minimal market correlation.

Discretionary Macro

The opportunity set for discretionary macro managers remains attractive, in our view, as markets have been responding with increasing frequency to dispersion in global economic fundamentals and fiscal and monetary policy paths. Managers can benefit from potential short-term dislocations arising out of leadership changes in Europe, US Congress, and several emerging market countries over the next few months.

Read the Detailed Outlook

For a more complete discussion of our outlook for each hedge strategy, download the print version.

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